Progressive State Income Tax Would Damage Michigan’s Economy

State Rep. Jim Townsend wants to amend Michigan’s constitution to allow a graduated state income tax, and raise the maximum rate to 10 percent. This would hurt the state as a whole, including those he wants to help.

The prosperity of this and every other state is determined by its rate of economic growth. And for growth, what matters is not the average tax rate but the marginal tax rate. That is, the amount of extra taxes an individual must pay on his or her next dollar of income. The higher the marginal rate the less incentive a person has to work overtime, study to get a better job, make an investment or take the risk of starting a business.

Townsend’s bill would increase the top state income tax rate from 4.25 percent to 10 percent, but this cannot be considered in isolation from the income taxes imposed by other layers of government. When federal income taxes are added, and in 22 Michigan cities local ones too, the highest combined rate on a Michigan taxpayer would jump to 52 percent under Townsend’s proposal, up from the current top rate of 46.25 percent.

There are some economic choices that make sense for an individual whose combined federal and state income tax rate is 14.25 percent — the lowest rate at which a dollar of income is now taxed in this state — but don’t make sense at higher rates. And when government takes more than half of the next dollar a person earns — as it would in some places under Townsend’s proposal — many individual decisions that would benefit this state’s economy would no longer make sense for the individuals making them.

Moreover, the damage to Michigan’s economy could begin very quickly given the amount of job- and business-establishment churn in the economy. More than 200,000 businesses opened or expanded in Michigan in 2013, adding roughly 800,000 jobs. On the other side, owners of around 190,000 businesses shed jobs or closed their doors altogether, costing roughly 750,000 jobs.

These decisions — whether to add or layoff one more worker, expand a firm or shut it down — are all made on the margins. Many factors go into such decisions, but marginal tax rates can have a powerful effect on tipping the scales for or against economic expansion. High marginal tax rates discourage activities that add or save jobs.

That makes it a fantasy to think such tax hikes would have no effect on business owners’ decisions, with potentially much larger consequences for those who work or would like to work for those firms.

Townsend’s proposal does lower marginal rates for some people. Rates would fall by 0.25 percent to 1.25 percent for individuals who earn $40,000 or less ($80,000 for joint returns).

But owners of the roughly 400,000 businesses who decide to expand, contract, open or close a Michigan business in any given year are more likely to be among those Townsend wants to pay more. Specifically, those with incomes higher than the amounts cited above would turn over an additional 0.75 percent to 5.75 percent of their income to the state. His proposed top rate of 10 percent is more than double the current flat rate of 4.25 percent

Supporters consider the proposed rate structure to represent a more fair tax system. But their analysis disregards the compounding effect of adding these rate hikes to the highly progressive federal income tax. The average federal tax burden for the bottom fifth of earners is just 1.9 percent, while it is 28.1 percent for the top fifth.

In addition, Michigan’s current flat income tax is more progressive than it appears on paper. Along with standard exemptions at all income levels, the state offers a “homestead property tax credit” and a bump to the federal Earned Income Tax Credit, which means many in the bottom tier of tax filers don’t just get tax refunds — they get a subsidy from other Michigan taxpayers.

Moving a bit further up the income ladder, the bottom third of people who file Michigan tax tax returns have no net state income tax liability whatsoever. And at the top end, 15 percent of the all state income tax collected by this state comes from just 0.7 percent of earners. Michigan’s “flat” income tax is already very progressive indeed.

So a graduated income tax would fix a “problem” that is already fixed, in a way that will harm the future of this state and all its residents — including those with low incomes.